Enlarge GraphMortgage applications, as reported by the Mortgage Bankers Association, fell 12% for the week ending June 28

Mortgage applications are primarily interest rate–driven. Applications typically increase as rates fall because homeowners take advantage of the drop in rates to refinance. Likewise, applications tend to fall as rates rise. Mortgage applications also show a seasonal pattern, correlating with purchase activity during the summer selling season. This year, we’re seeing strong origination volume growth, even as we see prepayment burnout. Prepayment burnout happens when interest rates fluctuate in a narrow range for an extended period. Each time rates return to a lower range, the number of prepayments (or refinances) drops. The mix of purchase activity versus refinance activity is tilting more towards purchases as the economy improves and refinance activity slows. This favors mortgage bankers (who have a strong retail branching system) and works against lenders (who go direct to the consumer).

The bond market sell-off continues

The MBA Mortgage Application index fell 12% to close at 550.5 after closing at 629.2 the week before. Given that borrowing rates fell 12 basis points, this is a surprising result. That said, applications have been falling since rates bottomed in late April. Combined with generally good earnings, the bond market has suffered from the “risk on” trade, which means investors are selling “riskless” assets (like Treasuries) to buy risky assets (like stocks). The final nail in the coffin was Bernanke’s press conference after the FOMC meeting, where he said the default path was to start reducing quantitative easing by late fall. The 30-year fixed-rate mortgage fell last week to 4.39%, but has increased about 1 percentage point in the last two months.

Mortgage bankers had an extremely profitable 2012, as rates fell and real estate prices bottomed. You can attribute much of the activity over the past five years to “serial refinancers,” people who have equity in their home and have taken advantage of refinance opportunities as rates have fallen. These borrowers are highly price-sensitive and tend to go with consumer-direct lenders who offer low rates and reduced application fees. These consumer-direct lenders will struggle in a purchase environment, and they have been laying off staff in anticipation of a drop in volume.

The purchase market is much more relationship-driven. This market requires a branch system of local professionals who have a large network of realtors, real estate attorneys, and similar professionals. These bankers compete on the basis of price and service. This also means that there’s competition for independent brokers and bankers. A mortgage banker can grow very quickly through M&A (mergers and acquisitions) activity.

Big opportunities ahead for mortgage REITs that focus on origination

The mortgage market is undergoing a massive transformation as the private label mortgage market returns. Bob Corker (R-TN) and Mark Warner (D-VA) recently introduced a bill to end the GSEs (government-sponsored enterprises) and put the government in a re-insurance role. All of the securitization that was done by Fannie Mae and Freddie Mac will now be done by private entities, some of whom could be mortgage REITs.

Ever since the bubble burst, mortgage origination has been almost exclusively government-driven. The big buyers of new origination have been the agency REITs like Annaly (NLY) and American Capital (AGNC). The U.S. government bears 50% of the credit risk of the entire U.S. mortgage market. Originators typically don’t hold their mortgages: they either sell them to the big banks or securitize them. Since the securitization market has been dead, originators have no outlet for non-agency mortgages. Redwood Trust (RWT) has been the only issuer of private label mortgage-backed securities (securities backed by mortgages that aren’t government-guaranteed), and they’ve focused exclusively on high-quality jumbo loans. Pennymac (PMT) noted on its conference call that it recently launched a jumbo product and is targeting a first securitization in Q3.

In the beginning of the year, we saw a wave of private label deals, but subsequently, spreads have widened and the deal flow has slowed. The recent back-up in rates has basically put a freeze on the private label market. At some point, the back-up has to affect jumbo pricing. The vast majority of the deals were extremely high-quality loans with significant over-collateralization, so they look nothing like the private label deals done at the end of the bubble. The sense is that more deal flow will happen once the government settles on how it wants to regulate private label securitizations. Finally, increases in origination will help servicers like Nationstar (NSM) and Ocwen (OCN).

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